The strength of the correlation between the U.S. dollar and equities can change due to fiscal policy, Federal Reserve policy, global monetary conditions and economic fundamentals. These changes can catch investors off guard. Understanding the reasons behind a move in the dollar is necessary in order to recognize its impact on equities.
Over the past decade, equities and the dollar have had negative and positive relationships depending on macroeconomic conditions. The negative correlation between the U.S. dollar and equities from February 2016 to May 2016 has inverted, due to new initiatives by overseas central banks and continued improvements in U.S. economic fundamentals.
S&P 500 and the Dollar
From February 2016 to May 2016, the SPDR S&P 500 ETF (NYSEARCA: SPY) rose 16%, while the PowerShares DB US Dollar Bullish ETF (NYSEARCA: UUP) declined 4%. During this period, the biggest gainers in the stock market were basic materials, energy and industrial stocks. However, this correlation shifted as the dollar began to rise slowly in May.
Many believed that this would result in the stock market giving back its gains. Instead, stocks continued to march higher with the dollar. From May 2016 to August 2016, the dollar was up 3.5%, while the S&P 500 was up 6%. The strongest gainers in this period were housing, financial and insurance stocks. Basic materials, energy and industrial stocks lagged the broader market, as they were hurt by the strengthening dollar.
Horseman Global Capital vs James MacKintosh
Even the best investors can fail to identify changes in correlation; Horseman Global Capital was one of the best-performing hedge funds in the world from 2010 to 2016. It had a short exposure of 98% in March 2016, since it believed that the rally in stocks would be short-lived due to weak economic fundamentals that would lead to dollar inflows.
However, its managers ended up covering these shorts and reducing exposure in April on positions that would rise with a stronger dollar. They continued to believe that equity prices would move lower but thought that the dollar would decline with equity prices. They took aggressive stakes in these positions. However, these positions have declined, as the dollar has actually strengthened with equity prices. Earlier expectations that a stronger dollar would result in lower stock prices also failed to materialize.
James MacKintosh addressed this fallacy among investors in a Wall Street Journal article titled, "Lower Dollar Means Higher Stocks, Right? Wrong" in May 2016. His thesis is that market participants often fail to account for the complex factors behind movements in the dollar, leading to incorrect positioning. As he states, "Sometimes moves in the dollar can cause moves in shares. Sometimes moves in both have a common cause. And sometimes they move independently." This lesson can also be learned from Horseman Capital's missteps earlier in the year.
Global Central Bank Policy and Improving Fundamentals
MacKintosh's main point is that investors should understand the factors behind movements in the dollar before determining their impact on equities. Making assumptions about the correlation can lead to poor outcomes. The rally in the dollar between May and August 2016 failed to negatively impact equities, because it was due to the Bank of Japan (BOJ) and the European Central Bank (ECB) moving towards more aggressive monetary policy, which weakened their currencies. The dollar's strength was due to weakness in the euro and Japanese yen, rather than risk-aversion or fears of a slowing economy. If dollar strength were a result of these factors, then it would have a negative impact on equities.
A rising dollar does have negative impacts on certain industries that are dependent on commodity prices or exports. If the broader economy is weak, it could lead to a recession. This is not the case in the dollar rally from May 2016 to August 2016. Economic fundamentals have improved with increases in wages, jobs, housing and consumer spending. This has been more than enough to offset the drag from industries that are negatively affected by a stronger dollar.
